Risk reward ratio (RRR) is an important concept in trading that allows traders to manage their risk and predict potential returns. It is a ratio that compares the expected amount of loss (risk) with the expected amount of profit (reward) on a given trade.
Imagine it like this:
For example, if a trader enters a trade where he can potentially gain $500, but he can also lose $250, the risk-reward ratio is 1:2. This means that for every $ they are willing to risk, they expect a return of $2.
It is important to remember that the risk-reward ratio is only one part of the decision-making process in trading. Traders should also take into account the probability that the trade will be successful.
Example: If the risk-reward ratio of a trade is 1:5, it may look like a great trade at first glance. But if the probability of the trade succeeding is only 20%, then the trader must consider whether the trade is still profitable.
This is the basic idea of risk-reward ratio in trading. It helps traders maintain discipline and manage their risk, which is a critical aspect of successful trading.